OPTIONS TRADING

Eldorado Gold At All-Time High

11/12/09 12:50:41 PMby Donald W. Pendergast, Jr.When a stock in a hot industry group makes an all-time high, should you jump on the momentum bandwagon and take your chances, or should you take a different route, one that stacks the probabilities of a winning trade in your favor?

Security:EGOPosition:Sell

The goldbugs of the world are walking tall these days. The metal of kings has sliced right through the $1,100 per ounce level, the fundamentals for the US dollar (whose price generally moves inversely to that of gold) couldn't be more abysmal, and central banks in Asia are steadily accumulating bars of the mighty AU (the atomic number assigned to gold) rather than stacks of ever-depreciating US currency. Shares of gold mining stocks are also joining this party, with some mining stocks making all-time highs. All of this sounds comforting for gold and commodity bulls, but therein lies the rub -- all of this ebullience and overconfidence running rampant throughout the goldbug and metals mania communities will sooner or later result in yet another significant corrective move, most likely down to key moving average support levels. And then the party will most likely start up again after a period of consolidation, possibly even taking the price of gold and gold mining stocks to new all-time and/or nominal highs. So what's a long-term goldbug to do now, realizing that a correction can appear at any moment, even though the long-term fundamental trend is still outstanding? Here's one idea, aimed squarely at goldbugs who prefer to traffic in the shares of the highly volatile and often profitable gold mining industry group.

FIGURE 1: EGO, DAILY. Breakout or fakeout? Who knows, but various option strategies can be applied to take advantage of nearly any trade setup.

Eldorado Gold (Figure 1) isn't as big a name as Newmont, Barrick, or Anglogold, but the stock has been grinding higher for many years, propelled consistently higher by ever-increasing earnings and rising institutional ownership percentages. The stock has just blasted above a well-formed daily price channel, with the Aroon (14) trend intensity indicator confirming the move up. Now that it's at an all-time closing high of $13.32 per share, what might be the sanest way to play such a major breakout by a stock that hails from one of the most emotionally charged industry groups of all? And how do we construct a trade that has a high degree of turning a profit, even if the price of gold takes a temporary tumble?

FIGURE 2: POSITIONS. Selling more calls than you buy? Yes, it's a ratio spread, one designed to profit if the stock declines or if it rises at a slow rate of ascent between now and April 2010 option expiration. Should the stock immediately accelerate higher, however, substantial losses can occur.

Graphic provided by: ThinkorSwim.

The answer, of course, is to play the trade by using options (Figure 2). Before we start, let's make it clear that this option strategy isn't for novices and it will require a bit of subjective judgment as far as deciding when to close the trade out for a profit or loss. That said, here's the game plan:

This is referred to as a ratio spread and the idea behind it is simple: if EGO declines, pulling back from this all-time high at a time of rampant gold optimism, the trade will make money as EGO declines over the short term.

For example, assuming a static level of implied volatility, if EGO were to decline to $12.25 on or about November 27, 2009, the trade could be closed out for a gain of about $67 before commissions. (That's why low-option commissions are preferred for this trade! At $1 per contract at Interactive Brokers, you'd incur $12 in round-trip commissions, reducing your net profit to about $55 for the closed trade.) So far it looks interesting, but what happens if EGO only pulls back a bit and then rallies sharply, say up to $15 by December 3, 2009? The trade will be underwater by about -$72, not including commissions, so if you use IB like I do, you'd simply close the trade out for about an $84 loss and wait for a better opportunity.

But wait -- there's more! What if a trader is modestly bullish on EGO, believing that the stock will rise at a more modest pace over the next few months -- what might the profit outlook be for such an anticipated outcome in the stock? Here's where option trading becomes downright fascinating. As long as EGO stays below $17.92 by April 2010 option expiration, the trade could be held for a final profit at expiration. However, if EGO rises quickly, the trade will generally be a loser; here are some time/price values for the trade at various stages:

Bottom line: this ratio spread offers protection if you're totally wrong about EGO's ability to rack up further gains, and that's because you're short more calls than you're long. If EGO reverses hard right out the gate, you can close the trade out for a modest profit (but only if you have $1 option contract commissions, of course).

If EGO rallies sharply after trade inception, the trade will be a loser and should be closed out if the spread doubles in price. That means if you sell it for $0.45 you automatically buy it back at $0.90 or above to avoid having the losses get out of hand on a runaway trend move higher. If the trade peaks soon and then pulls back and consolidates for a few months, this trade will do pretty well, as the previously shown time/price values demonstrated.

So how well do you think you can anticipate/predict the moves in EGO over the next few months? Trading a ratio spread might allow you to experience the best of both worlds -- the chance again for a decline in EGO and the opportunity for a more substantial gain if EGO rises at a much more subdued pace during the next five months. It's your call, if you'll pardon the pun.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.